Extreme Events – Specimen Answer A.8.2(a)
– Answer/Hints
[this page | pdf | references | back links]
Return
to Question
Q. Summarise the main risks
to which the following types of entity might be most exposed (and which it
would be prudent to provide stress tests for if you were a risk manager for
such an entity): (a) A commercial bank
Commercial banks are exposed to a variety of risks, but the
most important are usually:
i.
Exposure to interest rate movements. Commercial banks carry out maturity
transformation as they typically borrow short and lend long. Substantial
changes to yield levels (and to the shape of the yield curve) can give them
major headaches depending on their aggregate cash flow profile.
ii.
Exposure to liquidity squeezes. This was a particular issue for
commercial banks during the 2007-2009 credit crisis. Banks reliant on
particular markets for sources of funding can run into trouble if these markets
dry up. When designing suitable stresses it is also worth considering the
precise nature of the funding and the extent to which off-balance sheet
arrangements might cease to be off-balance sheet in a stressed scenario. For
example, several banks that ran into trouble during the 2007-09 credit crisis
were heavy users of ‘shadow banking’ structures, which ostensibly moved their
funding exposures to third party entities. However the liquidity squeeze during
the 2007-2009 credit crisis was so severe that these banks often found that
they had to support their own special purpose vehicles despite the aim being
that these vehicles would be ring fenced away from the bank’s own balance sheet
in adverse circumstances.
iii.
Credit risk and bad debts. A particular issue here is that the credit exposures
may turn out not be as diversified as the bank might have hoped. For example,
residential and commercial mortgage business may ostensibly appear to involve a
very diversified client base. However, it may actually turn out to be less
diversified than expected if there is a major economic downturn that coincides
with a major decline in general property values.
iv.
Operational risk. Like other financial services, commercial banks are
exposed to operational risks. These might include fraud (by the company’s own
employees or directors), or inappropriate incentive elements for employees or
within the products it is selling that lead to unhelpful aggregate customer
behaviours.
P.S. Similar types of risk (but in other guises) usually
arise with other types of financial services entities, which may be one
contributory factor in the increasing popularity of the discipline of
Enterprise Risk Management.
NAVIGATION LINKS
Contents | Prev | Next | Question